Are Companies Borrowing Themselves Into Trouble?
The stock market is soaring, with major indexes climbing into the stratosphere. Investors are even ignoring repeated warnings from Federal Reserve Chairman Alan Greenspan as they rush to buy shares. So companies are issuing mountains of new equity to take advantage of stocks' lofty levels, right? Guess again.
Even as the bull has trampled old records, U.S. corporations have retired more stock than they issued. Instead, they have gone on a borrowing binge the likes of which hasn't been seen since the late 1980s. In 1998, the Fed's most recent data show, net new borrowing by nonfinancial corporations hit a record $343 billion, rising by more than 10% annually for the first time in a decade. Meanwhile, equity outstanding decreased by $178.4 billion--either because of stock buybacks or mergers. And despite a flurry of initial public offerings from Internet companies, IPOs totaled just 73 in the first quarter of 1999. It was the third straight quarter with fewer than 100 IPOS--the first time that has happened since 1991, reports Securities Data Co.
SUBTLE SIGNAL? It's a remarkable about-face for corporate finance. Seared by the excesses of the 1980s, when crushing debt levels led to spectacular bond defaults and bankruptcies, companies spent most of the '90s cleaning up their balance sheets, restructuring, and paring down debt. But that trend has stopped for now. "Deleveraging has become passe," says John Lonski, chief economist at Moody's Investors Service.
Powering the borrowing surge are two other booms--one in mergers and acquisitions, the other in technology investment. Merger activity reached $1.62 trillion in 1998, according to Securities Data. And companies are loading up on new technology, boosting productivity but increasing their debt to do so.
Why aren't companies issuing more stock? One explanation is that despite the seemingly unstoppable rise of the big indexes, many stocks are languishing. And by issuing debt instead of equity, optimistic executives could be signaling that they think their stocks are still bargains. Consumers seem equally cheery: Their debt levels rose $8.7 billion in February, a 7.9% annual rate.
True, corporate leverage is nowhere near the nosebleed territory of the '80s. Net leverage--the result of debt added and shares bought back--averaged 143% of pretax profits from 1984 to 1989, hitting an all-time high of 207% in 1986, says Lonski. As corporations grew more conservative, net leverage actually became negative in 1991 before working its way back to 74% in 1997 and 122% last year.
Many companies have pared back debt so they could have borrowing capacity when they need it. Before AT&T issued a record-breaking $8 billion debt package in March, Treasurer Edward M. Dwyer says, "we hadn't been out on the road, from the debt perspective, for four years." Instead, the company sold off noncore businesses, raising $14 billion in cash. "We were very much positioning the balance sheet," says Dwyer.
At the same time, rates are so low that many corporations figure it's a good time to lock in financing. "I've always been a great believer in raising cash when the market offers it to you," says John R. Alchin, treasurer of Comcast Corp., the Philadelphia-based cable company that hiked long-term debt to $3.5 billion last year, from $2.6 billion in 1997. "If your back is anywhere near a wall, you get less favorable terms."
Still, the surge in borrowing may be a danger signal--an indication that some sectors of the economy are faring worse than the overall economic numbers suggest. Many companies are borrowing because internal cash flow isn't covering their investment needs. The corporate financing gap--the difference between capital expenditures and cash flow--grew from $5 billion in 1994 to $79 billion last year, according to the Fed.
For stock market bears, the debt fest is a clear sign that the economy is losing steam. "To sustain current levels of investment and hiring, business is being forced to borrow," says Charles I. Clough Jr., chief investment strategist at Merrill Lynch & Co. "That has profit implications." And corporate earnings grew by only 2% last year, the slowest advance since 1991, according to BUSINESS WEEK figures.
The added debt is already proving troublesome for some companies. Commercial loans more than 90 days past due rose from $802 billion at the end of 1997 to $906 billion in December 1998, says bank research firm Veribanc Inc. And U.S. bond defaults last year hit 36, the most since 1992, according to Standard & Poor's Corp. Says Leo Brand, analyst at Standard & Poor's: "I suspect if the economy takes a downturn, we are going to see huge numbers for defaults."
For now, that would seem to be the last thing on investors' minds. AT&T, for one, planned on borrowing $6 billion earlier this year. But it wound up increasing its offering by a third. And Dwyer says: "We had $18 billion in demand." Bankers say investors prefer bigger deals, seeing them as easier to trade.
In addition, just months after a flight to quality almost froze the credit markets, investors are eager for more yield--and they're willing to take risks to get it. In the loan-syndication market, volume fell from $1.1 trillion in 1997 to $872 billion last year, says Loan Pricing Corp. And totals for the first quarter are unlikely to match those of last year's first three months. But loans to leveraged borrowers soared from 17% of the total in 1997 to 31% in 1998.
Consider New World Pasta of Hershey, Pa. This year, the company planned on raising $110 million in debt at an interest rate of 10.5%. But investors were so eager that in February, New World Pasta signed off on a $160 million bond at 9.25%. "There is so much money out there today chasing few attractive deals," says C. Mickey Skinner, New World's chairman.
Another factor: In contrast to last year, "there was very little refinancing in the first quarter" of 1999, says Arthur P. Davis III, president of Loan Pricing. That means companies are adding on new debt--and risk.
NO STAMPEDE. Longtime market observers don't see the kind of excess that marked the 1980s, however. "It's not a wholesale stampede," says Davis. Even this year's biggest leveraged deal--Allied Waste Industries Inc.'s mostly cash $9 billion purchase of Browning-Ferris Industries Inc.--seems tame by 1980s standards. Allied expects its debt will amount to about four times its cash flow this year. In the 1980s, people cut deals with ratios twice as high.
On the other hand, the long decline in leverage appears to have ended. "At this stage, I would argue that corporate balance sheets are still in very good shape," says Douglas R. Cliggott, U.S. equity strategist at J.P. Morgan & Co. "What's new is they are not getting better." In other words, a turning point has been reached. And if the worriers are right, it could be a big one.